Buyer Beware: Strategies for Buyers of Companies With Underfunded Pension Plans
Corporate & Finance Alert
June 2, 2009
Buyers of companies with underfunded pension plans, otherwise known as defined benefit plans, have always flirted with danger. A buyer that acquires a company through a stock sale or merger assumes all the liabilities with respect to an underfunded defined benefit plan. A buyer that acquires a company through an asset sale does not assume any of these liabilities, unless the buyer agrees to assume the plan in the acquisition documents.
As a result of the decline in financial markets and low interest rates, the defined benefit plans of more and more companies have become underfunded. In addition, the provisions of the Pension Protection Act of 2006 have increased the funding obligations of companies that sponsor defined benefit plans. As a result, acquiring companies with underfunded plans through a stock sale or merger has become an even riskier business.
Under the Pension Protection Act of 2006, for plan years beginning in 2008, sponsors of defined benefit plans must make minimum annual funding contributions that will meet full funding targets and eliminate funding shortfalls by 2015. Plan sponsors must make these contributions when the value of plan assets is less than the funding target, which is the present value all accrued benefits as of the beginning of the plan year.
Furthermore, “at risk” plans have additional funding requirements and a higher funding target. A plan is at risk when the ratio of the plan’s assets to the plan’s funding target for the year, determined without using the special at risk actuarial assumptions, is less than 65% in 2008, 70% in 2009, 75% in 2010, and 80% thereafter (the “funding target attainment percentage”), and the plan’s funding target attainment percentage, determined using the special at risk actuarial assumptions, is less than 70%. When a plan is at risk for the current year and two of the prior four years, an additional loading factor of 4% of the funding target, plus $700 per participant, is added to the at risk liability.
In light of the current market volatility, the amount of the minimum annual funding contributions can change significantly from year to year. Accordingly, a buyer must make sure that the business acquired will generate sufficient liquidity to satisfy this obligation as currently calculated, and as calculated taking different potential financial market scenarios into account.
For fiscal years ending after December 15, 2007, the new FASB Statement No. 158 requires plan sponsors to fully recognize obligations from defined benefit plans either as an asset or liability in their statements of financial position, rather than in the notes to the financial statements. Plan sponsors must recognize the plan’s overfunded or underfunded status measured as the difference between the fair market value of plan assets and the projected benefit obligation. Plan sponsors must recognize changes in the plan’s funded status in the year the changes occur.
Although a company’s financial statements now provide more information, the information provided does not contain sufficient information for a buyer to determine the exact amount of the underfunding. Moreover, with the current market volatility, the exact amount of the underfunding can change substantially and quickly.
As a result, buyers continue to have to do substantial due diligence to determine the precise amounts of the underfunding and the minimum annual funding contributions. Buyers will also have to determine whether the business acquired will generate sufficient cash flow to meet the minimum annual funding contributions.
Once the buyer is confident that it has accurately determined the precise amounts of the underfunding and minimum annual funding contributions, the buyer can then factor these amounts into its determination of the appropriate purchase price. If the buyer finds that the amount of the underfunding, or the amount of the minimum annual funding contributions, is greater than it wishes to undertake, the buyer can then pursue the acquisition through an asset sale.
Should you have any questions regarding your own situation, please contact Steven H. Sholk of our Corporate Department.